What happens when a small Apple supplier loses its contract

Until Monday morning, Imagination Technologies was a successful processor technology company going through a bit of a rough patch. The company designed some of the underlying architecture of chips that Apple uses in its iPhone range, and as a result, it earns royalty money from every iPhone sold.

It’s a solid business model, so despite a downturn in iPhone 6s sales causing a cash shortage, Imagination was doing well. Emphasis on the “was.”

Early this morning, Imagination dropped a bombshell on its investors: Apple is planning a fundamental rebuild of the GPU used in the iPhone, to increase control over the design and to remove the need to pay Imagination royalties. As you can imagine, the result has been ruinous for Imagination.

In the hours since the press release dropped, Imagination Technologies stock dropped by 65 percent, as investors bail out hard. It’s a hard result for Imagination: though Apple’s revenue does make up about half of Imagination’s revenue in total, the stock has dropped by more than half. The revenue for Apple relates to patents and designs that Imagination already owns, so the marginal costs required to earn that cash from Apple are minimal. Without the promise of future cheap revenue streams from Apple, Imagination’s core business is left looking a lot more tenuous.

But before Imagination’s stock fully craters, it’s worth looking at the press release the company put out in greater detail. Imagination points out that it will be difficult to Apple to completely abandon the design and architecture that it pays Imagination for. Redesigning a new GPU may well reduce Apple’s reliance on Imagination’s design, but cutting out the company’s intellectual property altogether will be difficult. In a statement, Imagination described its reaction to Apple’s news:

Apple has not presented any evidence to substantiate its assertion that it will no longer require Imagination’s technology, without violating Imagination’s patents, intellectual property and confidential information. This evidence has been requested by Imagination but Apple has declined to provide it.

Further, Imagination believes that it would be extremely challenging to design a brand new GPU architecture from basics without infringing its intellectual property rights, accordingly Imagination does not accept Apple’s assertions.

Apple’s notification has led Imagination to discuss with Apple potential alternative commercial arrangements for the current license and royalty agreement.

That last line in particular raises the specter that this is just a bargaining move from Apple: announce it plans to sever ties entirely, watch Imagination’s investors freak out, and then offer the company a lifeline of reduced royalty payments.